A Fine Mess
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Having tried everything else, the senators finally turned back to Bill Bradley and his simple formula: broaden the base to lower the rates. At a Finance Committee meeting in mid-April, Chairman Packwood put aside the Christmas tree bill and handed out copies of the Fair Tax Act that Bradley had introduced years earlier. Just as Bradley had predicted, the lure of sharply lower rates proved stronger than the senators’ attachment to their special interest tax breaks. With Ronald Reagan and the liberal Democrats pushing together, the drive for genuine tax reform gathered so much momentum that the BBLR bill—the Tax Reform Act of 1986—swept through both the Senate and the House and was signed into law by a beaming president in October.
That 1986 law, generally recognized as “the most significant reform in the history of the income tax,”9 reduced the top marginal rate for individual taxpayers from 50% to 28%—the biggest reduction of any tax bill before or since. It did that by eliminating a broad range of “tax shelter” breaks available only to the rich. It cut back the deduction for mortgage interest and completely eliminated the deduction for interest on consumer loans, like auto loans and credit cards. It eliminated the deduction for state and local sales taxes. It limited deductions for charitable contributions, IRA deposits, medical bills, and other personal expenses. It set the tax rate on capital gains—that is, profit on stocks, real estate deals, and so on—at the same level as the top income tax rate, so that financiers could no longer cut their tax bill by defining all their pay as capital gains. In fact, the reform changed so many aspects of the tax code that the official name of the basic law of U.S. income tax was updated for the first time in thirty-two years. What had been the Internal Revenue Code of 1954 became the Internal Revenue Code of 1986, which it still is today.
The new law produced significant tax cuts for low-income and median-income Americans and provided tax savings for the rich as well. But somebody had to pay for all that lost revenue, and the burden was shifted largely to corporations. Although the bill cut the basic corporate tax rate, from 48% to 34%, it took away so many of industry’s cherished credits, deductions, and depletion allowances that corporate taxes increased by some $120 billion over five years.
In short, Congress and the president achieved a fundamental change in the income tax by heeding two lessons from the New Zealand reform: they broadened the tax base to make low rates possible, and they made a large, sweeping reform all at once so that every change the taxpayers didn’t like was offset by changes that they wanted badly.
This stunning and unexpected tax reform, particularly coming out of a politically polarized Washington, D.C., drew attention, and prompted action, around the world. When little New Zealand transformed its tax code, the other wealthy nations found it interesting; when the mighty United States did the same thing, the rest of the world found it imperative, on political and fiscal grounds, to do the same. In short order, Britain, Ireland, Canada, the Netherlands, and other democracies dramatically lowered their tax rates by broadening the tax base. The OECD called this wave of tax reduction a “global revolution,” and the United States lit the spark.
But soon the lobbyists and political contributors started leaning on Congress to restore many of the credits, exemptions, allowances, and shelters. Many industries got their depreciation or depletion allowances fully restored. Families got new tax credits for child-care expenses and student loan interest. Under pressure from Wall Street, the tax rate on capital gains was sharply cut; this was a windfall for the wealthiest taxpayers, and one that gave the finance community new incentives for complicated schemes to make salaries look like dividends. All these giveaways narrowed the tax base, which meant tax rates had to be increased to bring in the same amount of revenue. After three increases in the 1990s, the top marginal rate of income tax was back up to 39.6%, where it sat in early 2017. After proudly patting itself on the back because of the 1986 reform, Congress in the next three decades made more than thirty thousand changes to the 1986 code. Most of them ran counter to the ethos of BBLR. Virtually all of them made the tax code more complicated—including that bizarre “anti-complexity clause,” Section 7803(c)(2)(B)(ii)(IX).
Three decades after the passage of the 1986 reforms, the U.S. tax code is a mockery of the BBLR principle. It is stuffed to the roof with loopholes that narrow the tax base and thus force tax rates higher. If we are to fix our complicated and inequitable tax code again, Americans will have to agree—as we did three decades ago—to purge many of those deductions, including some of the write-offs that are most popular.
But which ones?
5.
SCOOPING WATER WITH A SIEVE
On a crisp, clear January night, the president of the United States travels to Capitol Hill to deliver the State of the Union address. After declaring that “the state of our union is strong”—they always say that—the president runs quickly through half a dozen minor policy proposals, pauses dramatically, and then sets forth the administration’s major new initiative for the year. “I will send legislation to Congress,” the president intones proudly, “that directs the Treasury Department to send a check for $7,500 to anybody who buys a $100,000 sports car. This will provide a generous handout to the wealthiest Americans and a major boon to automakers, including those in Germany and Japan. The average wage earner will get no benefit from this new program. By the way, it will increase the deficit by $700 million each year.”
Of course, that’s a fantasy. No president would make such a proposal. Welfare for the rich? Subsidies to foreign car companies? A serious increase in the deficit, with minimal benefit for average Americans? We would never establish a federal giveaway like that.
Except we already have.
In the Energy Improvement and Extension Act of 2008, Congress created a lucrative tax break—it’s Section 30(D) of the Internal Revenue Code—for people who can afford to buy electric or plug-in hybrid cars. It’s formally known as the “new qualified plug-in electric drive motor vehicle credit.” It says anybody buying a qualified plug-in electric car—the list of approved vehicles includes sleek, sporty cars like the $105,000 Tesla Model S P85D and the $138,000 BMW i8—can subtract up to $7,500 from the income tax he or she owes Uncle Sam. There are some less exotic cars that qualify—and get a smaller tax credit—but even those models, for the most part, are priced well beyond the reach of an American family making the median income.
In 2016, the IRS estimates, this tax credit reduced government revenues by about $740 million—money that would have come to the Treasury if the credit didn’t exist. That $740 million could have been used to treat wounded veterans or tighten border controls or reduce the deficit, if we hadn’t chosen to use it to subsidize upper-bracket auto buyers.
No president or member of Congress would dare suggest a spending bill that paid the rich for buying sports cars. But in Congress, Section 30(D) is not considered “spending”; it’s a tax credit. In the simplistic formula of congressional politics, spending is bad, and a tax break is good—even when they amount to the same thing. For the government, the impact is identical; the tax credit costs the same hundreds of millions as a spending bill. Because the language is different, though, Congress readily goes along with giveaways like this one.
Indeed, there are hundreds of credits, subsidies, deductions, and allowances scattered through the Internal Revenue Code that would never be authorized if proposed in a spending bill. “If tested in direct expenditure terms,” wrote Stanley Surrey, a renowned tax scholar at Harvard Law School, “many tax incentives will be seen as either inequitable—often to the point of being so grossly unfair as to be ludicrous—or ineffective.”1 Ludicrous or not, once these loopholes get into the code, they generally don’t go away. The individuals and corporations that benefit from these fiscal gifts fight fiercely to protect them against any efforts at repeal.
That’s why it’s so hard to achieve tax reform through the mechanism of broad base, low rates. Everybody agrees that B
BLR should be the driving principle behind the design of a tax system. But big, expensive giveaways like the credit for fancy sports cars keep working their way into the tax code. It happens in every country.
The easy part of BBLR is the low rates. Everybody likes lower tax rates. Economists tell us that low rates make the tax system “neutral.” If the tax burden is small, economic decisions will be based on business and personal considerations, not on tax implications. Governments like low rates because they make a tax system simpler to administer, and they increase voluntary compliance; there’s less motivation to evade taxes if the tax takes only a small part of your income. And taxpayers like a low rate because it makes taxation feel less like robbery.
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SOME OF THESE TAX INCENTIVES serve a useful purpose, encouraging good behavior and discouraging bad. Supporters of the “new qualified plug-in electric drive motor vehicle credit” would say it encourages people to buy environmentally friendly cars that don’t increase our need for foreign oil. But if that’s a legitimate purpose of the tax code, why would there also be a deduction for people who buy recreational vehicles, which are notorious gas-guzzlers?2 Congress doesn’t always act logically when handing out tax breaks.
If a government giveaway is justified by social benefits, its backers should make their case and ask Congress to appropriate the money. If a handout to a specific business or group can’t be justified as a direct government subsidy, it can’t be justified as a tax break, either.
The members of Congress who sponsor these loopholes know that many or most of them could not survive public scrutiny. In fact, the sponsors are so embarrassed to admit what they’re up to that they routinely conceal the real impact of a tax break behind obscure clouds of language that nobody can decipher (except the taxpayer getting the benefit).
Section 512(b)(15) of the Internal Revenue Code, for example, provided a tax exemption for any for-profit enterprise started on May 27, 1959, and owned by a religious organization. Its sponsor, Senator Russell Long of Louisiana, never mentioned that the only enterprise in the whole country that met these requirements was a commercial radio station in his state, WWL, a profitable business that was run by Loyola University. There’s another section of the code, pushed by the Michigan delegation, that gives special preference to “an automobile manufacturer incorporated in Delaware on October 13, 1916.” That would be General Motors, although the name of the firm does not appear.
This kind of loophole is known as a “rifle shot” tax provision, because it is sharply targeted at just a few specific taxpayers. Rich individuals and corporations are willing to pay for these favors—in the form of campaign contributions to the sponsors. That’s one of the reasons members of Congress are always eager to win a spot on the Ways and Means Committee—the tax-writing committee of the House of Representatives—or its Senate counterpart, the Finance Committee. Appointment to either of those committees opens the spigot for contributions to flow freely into a member’s reelection fund from donors hoping for a rifle shot of their own.
After loud complaints from journalists and tax-reform activists about deliberately murky legislative language—critics called it “taxation without comprehension”—Congress took aim at rifle shot taxation in 2007. Since then, the rules of each house urge—but do not require—the chairs of the tax-writing committees to identify the recipients of any tax break that benefits ten or fewer taxpayers. Because it is in the chairs’ discretion whether or not to make this information public, we don’t know whether Congress is still larding the tax code each year with giveaways for specific constituents. What do you think?
Among economists, there’s a term of art for this form of backdoor government spending. The various exemptions, exclusions, credits, allowances, deductions, and such are known as “tax expenditures.” This label was coined by the aforementioned professor Stanley Surrey. In the 1960s, Surrey took a leave from Harvard when his friend John F. Kennedy appointed him to the top policy position at the Treasury Department. This gave him access to all sorts of previously unpublished IRS data on giveaways in the tax code and their cost in lost revenue. When Surrey added them up, he was stunned to find how much revenue the government gave up, or “spent,” through tax breaks. Surrey’s office at the Treasury issued a report on this form of “expenditure” in 1968. It hit like a bombshell.
Until Surrey’s report, nobody knew how much revenue the government lost because of the various credits and exemptions. The 1968 report revealed the totals and made the comparison to the normal kind of government spending. It showed that the sum of the various giveaways was greater than the budget of any federal agency or program, including the Pentagon and Social Security. (It still is today.) Once Congress realized how much it was spending through the tax code, the concept of “tax expenditures” became a central element of tax policy. Today, Treasury is required by law to make public detailed listings each year on the amount lost through tax expenditures for both the individual and the corporate income tax.
Back in his classes at Harvard, Surrey attacked tax expenditures with great zeal. He loved to propose nutty hypothetical spending bills. When he taught his students about the deduction for home mortgage interest, he made it sound ridiculous. He laid it out something like this:
The federal government wants to help some Americans pay their mortgage. Here’s how it works: For a couple with $200,000 of income, and a mortgage interest payment of $1000 per month, the government will pay the bank $700 and the homeowners will have to pay only $300. For a couple with $20,000 of income and a mortgage interest payment of $1000 per month, the government will pay $190, leaving the couple to pay $810. For a couple making less than $10,000, the government will pay zero—so the low-income couple has to pay the full $1000 of mortgage interest.
Surrey would then point out that such a proposal—giving a big payment to the rich, a smaller payment to the middle class, and nothing to the poor—wouldn’t stand a chance in Congress as a direct appropriation. But, in fact, this system already exists—in the tax code. The mortgage interest deduction—or any deduction, for that matter—saves far more for taxpayers in the top bracket than for the average family or the poor. Surrey’s hypothetical was based on tax rates in effect at the time, when the top marginal rate was 70%. But even today, with a top rate of 39.6%, the mortgage interest deduction has the same reverse Robin Hood impact. It saves a rich family $396 for every $1,000 of mortgage interest due—but saves zero for low-income homeowners. Those who least need help get a subsidy, while those who most need it get nothing. This is a common pattern for tax expenditures. “The unfairness of the deduction,” Surrey wrote, “in its favoritism for upper bracket taxpayers is . . . evident.”
Tax expenditures take several different forms, and the structure of each tax break determines how it affects different groups of taxpayers. As Surrey taught, a deduction or an exemption from income gives a larger tax benefit to the rich, which he considered unfair favoritism. A tax credit, in contrast, gives the same benefit to all taxpayers.
If a tax preference is an “exemption” or an “exclusion” from income, then it reduces the amount of income you have to report. A “deduction” works the same way; a certain amount is deducted from the taxpayer’s actual income, to make his taxable income smaller. The tax rate is then applied to the taxable income; the higher the rate you have to pay, the more you save with each deduction. The result: a high-bracket family, paying 39.6% of taxable income, will get a larger write-off than a low-income family paying at the 10% rate. This benefits the rich more than the poor. The low-income taxpayers who need a tax cut the most actually get the least.
In contrast, a tax preference that is structured as a “credit” gives the average earner and the upper-bracket earner the same amount of tax savings. A credit is subtracted from the tax that is due after all the deductions and exemptions have been applied. Thus a tax credit of $100 will cut the taxes of the richest families by $10
0 and cut the average family’s tax bill by the same amount, $100.
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STANLEY SURREY’S NOTION OF tax breaks as “expenditures” caught on as well with the economists at the World Bank and the OECD. Those organizations quickly endorsed this American innovation and urged their member countries to tally tax expenditures annually in order to “clarify the trade-off between tax and spending programs in budget decisions.” Today more than two dozen of the world’s richest countries issue public reports each year on their tax expenditures. (South Korea compiles the same information but does not make it public.)3
Despite its prestigious academic pedigree and its broad international acceptance, the very concept of “tax expenditures” remains controversial, in the United States and in many other countries. The basic idea grates on people. If big government allows me to keep some of my own money in my wallet through a tax exemption, how can you call that “spending” by the government? It was never the government’s money to spend! Professor Surrey’s idea has been ridiculed from both right and left, by conservative Republicans and by Jon Stewart on The Daily Show. The British parliamentarian Stafford Northcote offered a famous denunciation of the concept: “The right honorable gentleman, if he took £5 out of the pocket of a man with £100, would put the case as if he gave the man £95.”
In the United States, the chairman of the Senate Finance Committee, the generally mild-mannered senator Orrin Hatch of Utah, was moved to uncharacteristic heat on this topic in a speech on the Senate floor. “The federal government cannot ‘spend’ money that it never touched and never possessed,” the senator complained. “What tax expenditures do is let people keep more of their own money.” Hatch argued that the whole idea of a “tax expenditure” was just a gimmick used by liberals to justify tax increases. “When tax hike proponents say ‘We are giving businesses and individuals all this money in tax expenditures,’ they are incorrectly assuming that the government has the money to give in the first place, when in fact it does not.”4